The settlement was filed in the US District Court ending eight years of court dispute between the utility and eight states that claimed to be affected by acid rain caused by nine of the company's power plants.
Fourteen environmental groups were also involved in the suit that concentrated on the company's breach of the Clean Air Act after the nitrogen oxide and sulfur dioxide emitted from the plants caused acid rain.
While AEP maintains it violated no environmental laws it agreed to annual emissions limits for all 16 of its coal-fuelled power plants in Kentucky, Indiana, Ohio, Virginia and West Virginia.
Two of those plants - the Rockport and Clinch River operations - will have emissions control equipment installed at a cost to the company of about $1.6 billion.
AEP has also pledged to spend a further $5.1 billion on reducing emissions across its fleet of stations by 2010.
A further $60 million will be spent by the company on rectifying the pollution caused by the plants, the majority of funds investing in federal government environmental projects and the remainder distributed to the affected states.
AEP chairman Michael Morris said the inclusion of a civil penalty was disappointing as his company is adamant it complied with environmental guidelines outlined in the New Source Review provisions of the Clean Air Act.
"While we would have preferred that the agreement not include a civil penalty - a position we argued vigorously during our discussions with the plaintiffs - this settlement is an excellent outcome for our shareholders," Morris said.
"It eliminates the potentially significant financial risk of pursuing the litigation to its conclusion while still achieving the environmental improvements that both we and the Government want."